PERSPECTIVES

OUR CENTRAL SCENARIO

ÉRIC BERTRAND
Deputy Chief Executive Officer,
Chief Investment Officer
OFI INVEST

The central bankers have spoken, and the markets have now priced in a “high for long” scenario, not just for 2024 but also for the following years.

Yield curves are now assuming higher short-term rates for the medium term, just as some central bank governors have raised their equilibrium short-term rate projections (the famous R*). Inflation data, particularly in core inflation, are on the right track, especially the latest European figures which should satisfy the ECB, but surprisingly resilient growth in the United States is having a significant impact on the term premiums.

We have taken note of these anticipations in raising our mediumterm targets on 10-year yields to 2.75%, 3.25% and 4.25% on 10-year German, French and US yields. We nonetheless believe that current levels, which are being driven in part by higher energy prices, are buying opportunities given that the expected economic slowdown, in particular in the United States, has merely been postponed until the first half of 2024.

For the aforementioned reasons, the credit market continues to perform very well and we continue to overweight bonds, whether investment grade or high yield. In high yield, we prefer the highest rated companies, as the lowest-rated ones are likely to ultimately take a hit from higher financing costs and the economic slowdown.

The equity markets stalled for the second consecutive month, in reaction to higher interest rates. We are sticking to the tactically cautious stance we adopted in February, but we are beginning to move closer to levels suitable to re-sensitising the portfolios. However, the financial markets do not yet seem to have priced in the likely downgrades in earnings forecasts for the coming year driven by the economic slowdown. In our view, the US market would be impacted more by this than Europe market.

OUR VIEWS AS OF 05/10/2023

The ECB raised its key rates by 25 basis points, while the Fed kept its rates unchanged. Despite tough talk on inflation, central bankers’ action were more in line with a long plateau scenario on key rates. Despite rising long bond yields, a T-Note around 4.60% and a Bund near 2.90%, we remain bullish on bonds. We see little room for higher rates, given the risks of undermining macroeconomic momentum. We continue to prefer the money market, given its attractive risk-reward ratio. High yield corporate bonds offer especially attractive spreads, thanks to their high carry. This was borne out this month, with the asset class performing in positive territory amidst rising interest rates. Short-dated investment grade corporate bonds also look worthwhile, as the yield curve is relatively flat.

The equity markets are currently being torn between, on the one hand, short- and long-term interest rates that are higher than expected just a few weeks ago, and, on the other, fears on companies’ ability to keep their margins up amidst weaker global growth. Upward pressures on rates is bad news for two reasons. First, because they, in effect, raise companies’ financing costs, particularly those companies that have to borrow to finance their growth. And, second, because the fixedincome markets are offering a true alternative to the equity markets, which had not been the case in recent years. This is why we prefer to stick to the defensive bias we adopted in early February. Geographically, higher rates are likely to penalise the US market first, as it has more growth stocks and is also being hit by the strong dollar.

The dollar’s strengthening vs. the euro reflects the wide divergence between US and European growth. The prospect for higher rates for longer, with or without a new Fed rate hike by yearend, continues to support the greenback. The yen is also being squeezed by the dollar’s strength. Beyond possible moves by Japanese authorities to shore up the yen, a more sustained appreciation will not come until there is better visibility on the normalisation of the Bank of Japan’s monetary policy.

MACROECONOMIC VIEW

WILL THE US RUN OUT OF RESILIENCY LATE THIS YEAR?

OMBRETTA SIGNORI
Head of Macroeconomic Research
and Strategy
OFI INVEST ASSET MANAGEMENT

The US just barely averted a government shutdown in late September. However, this risk was only postponed, given that US government financing is in place only until mid-November, and Republicans and Democrats remain fundamentally at odds on how to fund the government over the long term. The two sides could become even more polarised in the run-up to next year’s elections.

On the economic front, the US has exceeded all growth expectations so far this year. High-frequency economic data suggest that activity is still strong and is even accelerating. Moreover, the revised national accounts point to greater solidity for both companies and individuals. Earnings forecasts have been revised upward despite interest rate hikes by the US Federal Reserve since March 2022, and US companies’ debt-servicing costs as a percentage of their revenues is at a low since the mid-1960s at 1.8%.

As for households, surplus savings as of the end of August were estimated at about $1,000bn, revised upward from $600bn; how these will be used in the future is not certain, but they do offer a solid financial cushion for the economy.

The Fed has taken note of this resiliency, raising its growth forecasts for this year and next year at its September meeting, to, respectively, 2.1% and 1.5% year-on-year in the fourth quarter.

WHAT ARE THE RISKS TO US GROWTH?

Apart from an economic slowdown that has not yet occurred, there are three one-off risks to growth between now and yearend. The first of these is a possible government shutdown, a risk now postponed to November. The second is the strike in the auto sector, the impact of which will depend on how long it lasts and how intractable it is. The third is the resumption of student debt repayments, whose impact could vary with income category but which should be cushioned by the use of surplus savings, particularly in wealthier households.
Regarding prices, the disinflationary trend continues, although higher oil prices (and, hence gasoline prices) could boost US total inflation from 3.7% to about 4.5% by yearend.

This is cause for concern, but, for the moment, it does not seem to have derailed prospects for inflation to gradually convergence towards 2% by the end of 2024.

ENCOURAGING SIGNS ON INFLATION IN THE EURO ZONE

The euro zone’s economy is clearly diverging, and, on average could be in contraction territory in the third quarter. However, based on European Commission surveys and purchasing manager indices (PMIs),things are no longer worsening, in particular in Germany. In September, inflation receded more than expected, including core inflation, which is good news. Total inflation fell to 4.3% yearon- year (from 5.2% in August), and core inflation to 4.5% (from 5.3%). This trend was driven both by significant base effects on energy prices and transport services, particularly in Germany, and by a slower increase in prices of manufactured goods and services. Although risks in the euro zone continue to trend downward, disinflation is encouraging for household purchasing power, especially as wages continue to catch up.

CENTRAL BANKS ARE STILL ON HIGH ALERT

To sum up, economic data continue to keep central banks on high alert with regards to inflation. It is far too premature to look ahead to possible key rate cuts at monetary policy committee meetings. On the contrary, most Fed governors, for example, believe that one last rate hike would be appropriate by yearend. Our view is unchanged that that key rates will remain high for an externed period of time.

INTEREST RATES

A PLATEAU THAT SIGNALS STABILITY?

GEOFFROY LENOIR
Co-CIO, Mutual Funds
OFI INVEST ASSET MANAGEMENT

Central banks appear to have reached their famous plateau – a plateau that is likely to last for as long as inflation and growth remain high. The ECB raised its key rates by 25 basis points in mid-month, its 10th consecutive rate hike, and its deposit rate is now at 4% - a record for the ECB. However, the outlook for stable key rates will not necessarily mean stability on the bond markets and in particular for sovereign yields, as the ECB must get inflation down to 2.0% (from its current estimated 4.3%) while being careful not to derail the economy. This is an especially challenging tightrope to walk, especially with oil prices so high (Brent rose by 9.71% on the month).

THE RISE OF LONG BOND YIELDS

From 2.47% at the end of August, the 10-year Bund yield accelerated upward, hitting 2.93% at the end of September.

The increase was driven mainly by real rates, which could back a stagflation scenario. This acceleration was caused by several factors. First, the ECB’s rate hike had not been fully priced in by the markets, and long-dated bond yields had to adjust. Second, fears of more sustainable inflation, with higher oil prices and wages, have pushed back rate-cut anticipations. And, third, 10-year US yields rose from 4.10% to 4.65% on the month, a fifth consecutive monthly increase. This pushed European yields upward amidst positive revisions on growth and on a Fed status quo.

This comes on top of the risks of an acceleration in quantitative tightening (QT), of a US government shutdown, and of governments’ fiscal standings. The markets therefore do not appear to have overreacted in the short term. Against this backdrop, long bond yields have exceeded our forecasts. Our baseline scenario of a soft landing in the economy nonetheless remains favourable to bonds. Higher yields, in our view, are a buying opportunities in bonds. Yes, term premiums are reforming as the yield curve steepens again, but we see little upside potential, particularly in the US.

We would not rule out the scenario of a slowing in macroeconomic momentum in the coming months and are therefore sticking to our neutral stance on a Bund equivalent higher than 2.60%.

THE CREDIT MARKET HAS PLAYED FOR TIME AT A LOWER COST

There is a lag between higher rates and the financial standing of private-sector companies, which are mitigating the impact of higher rates through the surplus savings that they piled up at very low rates, particularly in 2020 and 2021, and by refinancing their debt. This is softening the impact of more expensive debt, which is unlikely to show up for another few quarters. Investment grade companies are unlikely to be squeezed too much by refinancing needs, thanks to rather long-dated maturities. As for high yield, refinancing is expected to accelerate in the coming months, but out of the 4.50% increase in key rates, only 0.60% has shown up in companies’ financing.

With its high carry (almost 8%), we still see high yield as an especially attractive asset class, on the condition of being selective. The month of September illustrates this perfectly. Despite a negative performance by sovereign and corporate bond indices on the month (respectively -2.56% by the JP Morgan EMU All Maturities and -0.86% by the Bloomberg Barclays Euro Aggregate Corporate), high yield corporate bonds managed once again to eke out a positive performance on the month (+0.29% by the Bloomberg Barclays Pan European High Yield Euro). The carry trade and short-dated maturities thus offset the increase in long bond yields.

EQUITIES

“GOOD NEWS IS BAD NEWS!”
IS BACK!

ÉRIC TURJEMAN
Co-CIO, Mutual Funds
OFI INVEST ASSET MANAGEMENT

That, in a nutshell, is the conclusion we can draw from September on the equity markets. With the exception of Japan, they continued to decline, as they had since summer, whereas economic news has been surprisingly good, particularly in the US. In short, the better things get, the worst they get. The answer to this enigma is once again to be found, of course, in shifts in real interest rates, which continue to thwart forecasters by moving up. The finger could also be pointed at the US Federal Reserve, which has hinted that interest rates could (should?) remain higher for longer.

CONSUMPTION REMAINS STRONG

Business confidence indicators are improving, the economy continues to create more jobs than expected, and retail sales are solid, suggesting that the propensity to consume is intact.

This is all the more remarkable as US consumer confidence indicators are receding and as an increasing share of purchases are now being made on credit, despite consumer lending rates that are setting one record after another. The debate continues on the outlook for consumption. On the one hand, the end of the moratorium on student loans should naturally impact consumer purchasing power, given that most surplus savings have been used up. But on the other hand, the prospects have probably never been so good for wage growth.

EARNINGS FORECASTS CLOSELY WATCHED

The strike by the United Auto Workers (UAW) suggests that the balance of power between employers and employees appears to have reversed itself in the US. The trade-unions are calling for a 40% salary hike over the next four years, and almost 30,000 employees have halted work at the three main US automakers (Ford, GM and Chrysler*). This alone illustrates our quandary on US equities. Will companies manage to preserve their margins while some of their costs continues to meet upward pressures and end-demand could ultimately be undermined by the effects of monetary tightening? We continue to believe that the consensus forecasts on US companies are too high for 2024.
Analysts will no doubt have to adjust their forecasts downward in the coming months, and this seems to be at odds with any gains to come in the S&P 500, given that valuation multiples are still above average.

A SQUEEZE BY HIGH INTEREST RATES

The ECB, meanwhile, has raised rates again, but while hinting that this was probably the last time. Economic figures are indeed still glum but may have bottomed out. The business confidence index has rebounded slightly, but inflation is above forecasts and is driving a rise in long bond yields that is hitting richly priced sectors hard. Some of these, moreover, are being hit by a doublewhammy, luxury goods, for example, which is feeling heat from the failure of the Chinese economy to take off. Some stocks, which investors had piled into for their long-term growth prospects, are now more than 20% off their highs.
Ultimately, while priced low, European equity markets, in our view, are being torn between short- and longterm interest rates which continue to be pushed up, and a global growth outlook that is likely to trigger downgrades in analysts’ earnings forecasts. This is why we prefer to stick to the defensive stance we adopted in early February.

EMERGING MARKETS

PANORAMA OF EMERGING ASIAN EQUITY INVESTMENTS

JEAN-MARIE MERCADAL
Chief Executive Officer
SYNCICAP ASSET MANAGEMENT

Retrenchment is a natural reaction to a very tense global political context. Moreover, Wall Street’s spectacular outperformance in recent years has tended to take some shine off emerging market equities, particularly Asian and Chinese ones. What to make of this situation?

Chinese equities have become “the most hated asset class”, according to a recent survey of major US investors, as three major recent events have raised eyebrows.
First, politically, Président Xi Jinping’s decision to stay in office for a third term and probably for life, raises the issue of an extreme concentration of power and the accompanying governance risk. Second, the sudden regulatory crackdown did give pause. And, third, the virtual bankruptcy of major property developers and the bursting of the real-estate bubble remain sources of concern. All of this has undermined confidence.
The Chinese economy’s medium-term growth potential is therefore due for a downgrade, and the government’s target to double the size of the economy by 2035 (which would assume an annual growth rate of at least 4.5%) is looking shaky, as is its goal of becoming the world’s largest economy by 2049.

CHINESE EQUITY DOWNGRADES

The result of all this has been a sort of investor capitulation, and Chinese equities are near their lows. Valuations are rather low, with a 12-month forward P/E of about 11, assuming earnings growth of about 10%. In this context, in which beta could be challenging, it is better to stick to alpha and seek out the most promising growth sectors.

After a first half of the year dominated by news on state enterprises and energy sectors that are mostly inaccessible to investors, the outlook is more promising for green energy, “nondurable” consumer spending (leisure and tourism), healthcare & well-being, e-commerce, etc. Keep in mind also that China remains a top-tier industrial power with a huge domestic market. A rally soon in Chinese equities would be no surprise, given the upturn in the latest economic indicators. While still under the 50 threshold – which separates growth from slowdown – the PMI manufacturing index has improved for the third consecutive month to 49.7, slightly above forecasts. Moreover, historically, the “A” market for locally listed Chinese equities achieved an average gain of 8% in the three months after the pullout of international capital of the same order of magnitude as that seen in the past two months, i.e., USD 16.2bn. And, lastly, China is simply too big to ignore. It is prominent in international indices, and international investors are likely to come flowing back in the event of an upturn.

TAKE A LOOK AT OTHER ASIAN COUNTRIES

Countries like India, as well as Korea and Taiwan are receiving both direct and financial investment flows that are now side-stepping China (the “derisking China” strategy).
India – which accounts for almost 30% of the Asian equities universe ex China - is a growing market and being priced as such, with an economy expected to expand by almost 6% this year and next. The other large markets are Korea and Taiwan, which feature large numbers of industrial and technological companies, followed by market that are smaller but also developing, such as Indonesia, Malaysia, Vietnam, etc.

To sum up, we reiterate our view of Asian equities, to wit: it’s better to think in two dimensions: China and ex China. These two zones are on different paths while being complementary and attractive.

FIGURE OF THE MONTH

200 bp

This is almost the spread between 10-year US and Chinese bonds, a 10-year high. Meanwhile, US stocks are trading at a 2023 P/E of almost 18, vs. 11 for Chinese equities.

10-YEAR US AND CHINESE GOVERNMENT BOND YIELDS

Document completed on 05/10/2023